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Government Debt Has No Upside

There are numerous clichés concerning the national (i.e. federal government) debt. In this article I attempt to show the grain of truth (and pile of falsehood) in these typical statements. But before doing so, I will first give a quick primer on government debt and its financing.

GOVERNMENT DEBT

When the government spends more than it takes in through taxes or other methods of acquiring funds (such as printing money or auctioning off federal land), it must make up the difference by borrowing. This shortfall between current revenues and current expenditures is the deficit. If revenues should exceed spending, the difference is a surplus. The overall debt is the sum total of all previous deficits and surpluses (due account being made for interest). When the government runs a deficit, the debt goes up, while running a surplus allows the government to pay off some of the debt.

Just as in the private sector, when the government needs to borrow it issues bonds to lenders. The essence of such a transaction is quite simple; the government sells an IOU right now for cash, and at some future date the holder of the IOU redeems it. Because of positive interest rates, lenders never pay the full face value of a bond when it is first issued. For example, if the interest rate is 5 percent, an investor would only be willing to pay (approximately) $95.24 now for a note that will pay $100 in twelve months. It would be silly to pay any more than this price, because (by assumption) the investor can lend his funds out at 5 percent, and $95.24 x 1.05 = $100.

The discounted price of bonds (relative to their face values) at time of issue also explains the interest cost of servicing the debt. For example, suppose an initially debt-free government runs a $10 billion deficit. It raises the needed funds to cover its excess spending by issuing 105 million one-year notes, each with a face value of $100. (Each such bond fetches $95.24 from a capitalist, and $95.24 x 105 million = $10 billion.)

Now suppose that this hypothetical government, following this one-shot deficit, runs a balanced budget year after year indefinitely. Even so, every year it must "roll over" the one-year notes. That is, every year 105 million notes are turned in to the Treasury, with people demanding their $100 per note. After redeeming all of the maturing notes, the Treasury reissues 105 million one-year notes, raising $10 billion again. However — and this is the crucial point — because of the discount, the government loses money every year during the roll over. When the 105 million notes are redeemed for their full face value, the Treasury pays out $100 x 105 million = $10.5 billion, whereas it receives only $10 billion from reissuing them. Thus, in order to perpetually carry a debt of $10 billion, the government must devote (out of general tax revenues) $500 million annually to interest payments. (Of course we have assumed a 5 percent interest rate throughout.)

We are now in a position to examine some of the clichés concerning government debt.

"A SIZABLE NATIONAL DEBT IS GOOD BECAUSE IT GIVES THE CITIZENS AN INCENTIVE TO SUPPORT THE GOVERNMENT."

I have never seen a textbook discussion of colonial America that didn't mention this alleged wisdom from the champion of infant industry, Alexander Hamilton. The idea is quite simple: As we have seen above, the national debt consists of financial claims (such as government bonds) against the Treasury. The holders of these bonds would be disappointed, therefore, if the government fell, because then their bonds wouldn't be paid off.

What the textbooks fail to note is that (typically) the government can only pay off its creditors by taxing the money away from them first. Suppose you lend me a $20 bill, and I give you a piece of paper saying, "IOU $20 next Monday." I take my fresh twenty and go spend it on a nice dinner. Then Monday rolls around and you hand me the piece of paper. I reach into your wallet, pull out a different $20 bill, and hand it to you as I crumple up the IOU. Aren't you glad I didn't get hit by a bus Sunday afternoon? You might never have gotten paid back!

Of course, the real logic behind Hamilton's proposal is that wealthy capitalists could lend money to the government, which would then levy taxes on the general public to pay off the bondholders. In this more realistic scenario, the privileged few would indeed support the regime, because it pledges to use its coercive powers to transfer wealth into their pockets. But if this is the mechanism we use to gain support for the regime, why go through the shenanigans of issuing debt? The government could just openly state to the elite, "Support us and we will use our guns to siphon off money from the unorganized rabble every year and give you a cut." (Now that I think about it, that probably wouldn't have been too popular, and even history textbooks might not have approved.)

"WHEN THE GOVERNMENT RUNS A DEFICIT, WE ENJOY HIGHER CONSUMPTION AT THE EXPENSE OF FUTURE GENERATIONS."

As we shall see, there is a certain sense in which this statement is true, but generally speaking it is very superficial. As Ludwig von Mises pointed out, in order to consume in the present, resources must be used in the present. When the government runs a deficit, politicians don't use a time machine to literally steal TVs and pizzas from people in the year 2050 and bring them back for our own consumption.

Perhaps the easiest way to see that something must be wrong with the conventional wisdom is a financial analysis: Yes, running deficits now means that our children and grandchildren grow up in a country with a higher national debt than they otherwise would have. But at the same time, running deficits now means that our children and grandchildren inherit more Treasury notes from us when we die.

As I noted, there is a certain truth to the statement. Government deficits siphon savings from the private sector and thus divert real resources from potential investment and waste them on unproductive lines. This means that the structure of physical capital goods that the next generation inherits will be less developed than if the government had refrained from deficit spending. In this sense, our descendants will indeed be materially poorer, because their labor and other resources will be less productive (since they are augmented by fewer tools and equipment). But the point is, it is not the accounting figure of the national debt per se that indicates their relative impoverishment; rather, it is the reduced supplies of capital goods with which they can work. This insight leads to the final cliché:

"THE DEBT IS HARMLESS BECAUSE WE OWE IT TO OURSELVES."

From an accounting viewpoint, the federal debt is a wash for the country as a whole (assuming it is US citizens who own the debt). Each government bond represents a claim on taxpayers, but if those bondholders consist entirely of US taxpayers, the size of the debt is irrelevant to total financial wealth.

However, there are two fundamental problems with this type of analysis. First, as we saw in the Hamilton section, it ignores the fact that not all people are identical; some groups may suffer on net while others may gain. For example, a poor immigrant with no savings who lives paycheck to paycheck certainly will not find the higher taxes (necessary to service the debt) to be exactly offset by the dividend stream yielded by his portfolio of Treasury notes.

Second, as we saw in the previous section, the flippant dismissal of the significance of the debt ignores the fact that deficit spending isn't just an accounting operation. When the government buys things, it really does consume resources that might have been devoted to other ends, and in particular might have been devoted to the production of capital goods.

Even if everyone were identical (so that there were no distributional effects), it certainly makes a difference if the government, with a tax revenue of (say) $1 trillion, decides to spend $1 trillion versus $1.5 trillion. In the latter case, the government's behavior will almost certainly reduce the amount of gross investment, and hence production in future decades will be lower than it otherwise would have been. This technological fact cannot be offset by pieces of paper issued by the Treasury.

Of course, some readers will object that I am overlooking the most salient problem with our current state, namely that foreign individuals and governments are financing American profligacy by buying up US corporate and government bonds. Yet I have always been troubled by the emphasis on the nationality of bondholders, because it implies that federal deficits are benign so long as "we owe it to ourselves." As we have seen, this is simply not the case.

CONCLUSION

Government finance is a messy affair, particularly when politicians use "off budget" expenditures and other gimmicks to cover their tracks. However, the basic principles are quite straightforward. If we are careful to avoid thinking in terms of simple aggregates, and keep in mind the role of savings and investment, we can spot the fallacies in popular statements concerning government deficits and debt.

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